Relying on equities for growth is no longer possible or desirable. Chris Panteli looks at the range of alternatives trustees are turning to as a result
Continuing uncertainty over equities and bonds is likely to drive pension funds into alternative growth assets in their search for yield this year.
In a bid to improve governance and risk management in particular, schemes are increasingly likely to eschew the traditional asset classes in favour of classes such as emerging market debt, hedge funds and commodities.
The financial crisis led many pension funds to take a close look at their governance practices, with risk management being the key area of focus. As a result, many have reduced their allocation to equities.
Mercer European head of investment consulting Tom Geraghty said schemes have regarded governance and risk management as key themes over the last two years and have taken steps towards improving asset liability management.
“There has been a continued movement towards de-risking and what I mean by that is a lowering of overall equity allocations,” said Geraghty.
However, while this has led to a reduction in equity holdings, it begs the question of what asset classes schemes should move into. While fixed income has been the obvious choice in the past, Geraghty added current economic conditions make such a move difficult.
“The obvious option for many funds has previously been a move into fixed income, but with interest rates in the UK and elsewhere at rock bottom levels and showing no signs of budging, domestic bonds are proving an expensive option for schemes.”
As a result, schemes have diversified into alternative asset classes, with a growing number of providers offering absolute return vehicles which give investors access to a basket of alternatives, Geraghty said.
“There is only so far pension funds are willing to go in terms of fixed income and what we have seen is a growing trend towards diversification into alternative areas such as emerging markets, both equities and debt,” he said. “We have also seen movement towards commodities, infrastructure, hedge funds etc, with providers in the market place coming up with multi-strategy products that are absolute return in nature.”
Research by Mercer shows this is particularly evident in the more mature defined benefit markets such as the UK, where equity allocations fell from 54% in 2009 to 50% in 2010. In Ireland it reduced from 60% to 59% and in the Netherlands from 28% to 23%.
This trend is likely to continue, Mercer believes, with 29% of UK schemes and 35% of European schemes (ex-UK) planning further reductions in domestic equity.
Meanwhile, a further 20% of UK schemes and 33% of European schemes (ex-UK) are planning a reduction in non-domestic equity.
Aon Hewitt principal consultant in the global investment practice John Belgrove agreed. He said de-risking is now the focus of most schemes, and by and large it has become a waiting game by trustees in terms of affordability around the extent to which that de-risking can accelerate.
“Coming from an industry that was very equity dominated, there has been a fairly long term trend of less reliance on equity as the return engine and more diversification into other asset classes,” he added. “Within equities it’s been about globalisation, so less reliance on domestic equities and more reliance on global and more reliance on active management.”
Outside of equity, Belgrove says the biggest growth has been seen in the use of hedge funds, commodities, infrastructure and property.
“The really big question is around risk mitigation,” he adds. “It’s one thing to diversify your growth assets which you’re still aiming to earn returns from, but the other part is how quickly and how deeply do you mitigate the interest rates and inflation risks that are out there by extending the bond portfolio or putting in place an LDI portfolio and swap overlays.
“There has been a lot of watching of that going on and our view has been to expect higher gilt yields, which we are starting to see now. We are now looking at 4.5% on 30-year government bonds and it is starting to get to the levels where there is more affordability.”
This move away from equities to a more diversified set of growth assets has been central to an investment strategy rethink at The Pensions Trust in the UK. The third sector multi-employer fund recently decided to reduce its exposure to shares and instead concentrate on alternative growth assets to hedge against risk.
The strategy has been divided into three categories: quoted equities, alternative liquid growth and alternative illiquid growth, and will include the execution of a common interest rate and inflation risk hedging to focus on the management of asset-liability outcomes rather than managing the assets in isolation.
“I don’t think we’re unique in this,” said chief investment officer David Adkins. “The key features are trying to diversify away from just quoted equities within our growth assets. These are themes that UK pension schemes have been following for some time and we’ve got eight alternative investment mandates already established, admittedly that includes three in property, and there’s going to be a few more coming onstream over the next 12 months.
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